Discount and Capitalization Rates

When someone mentions the word discount rate, you often think of the Federal Reserve Discount Rate, Federal Funds Rate, Expected Rate of Return, Cost of Capital, Required Rate of Return or Capitalization Rate. Most of these terms mean the same thing or are derived from each other. However, the Federal Reserve Discount Rate is the rate at which the Federal Reserve loans money to banks. The Federal Funds Rate is the rate at which the Federal Reserve expects banks to loan money to each other. We are not discussing the Federal Reserve Discount Rate or the Federal Funds Rate in this video. In this video we will discuss rates used to analyze businesses, cash flow or other financial decision making. Some people have what is called a Personal Discount Rate. This helps them make financial decisions the same way a discount rate can help a corporation or investor make decisions. For example, if someone offered to pay you $100 for 10 years  or a lump sum of $853 which would you select? That would depend on what your personal discount rate is. If it was 3% either one would be the same. If, however it was 4% you would be better off taking a lump sum payment. The discount rate is a very important tool that you can apply to investment decisions, valuations or analyzing different cash flows. The great importance of the discount rate is not that it provides you with the correct answer for investment opportunity, but rather it provides a framework under which you can analyze the investment and develop a much deeper understanding of your choices. The definition of discount rate is the rate of return used to discount future cash flows back to the present value. One of the top things to decide is how you calculate or find your discount rate. Typically, the best way to determine a discount rate for a company is to see what that company is required to pay investors to invest in the business. For example, if a company needs to pay investors 15% to make investments in the business then that would be there discount rate. Think about it this way, if they are borrowing at 15%, they would need to make at least 15% in the company otherwise they would be destroying value. A simple way to think about this is to assume it will cost you $100 to make a product, you would have to sell it for at least $100 otherwise you would be losing money. Preferably you would like to sell it for $125 or $150 and make a profit. Discount rate or your cost of capital is the same concept.   Sometimes, companies will use what is called the buildup method in order to find their discount rate. The buildup rate can be obtained by doing the following: Safe Rate Equity Risk Premium Size Premium Specific Company Risk Premium   From this you will be able to determine the discount rate.     Once a company has its discount rate it just has to subtract the growth rate to get what is called a capitalization rate 14.05% (17.04-.03). The below chart shows an analysis of Free Cash Flow and utilizes both a discount rate and capitalization rate to arrive at the present value of 192 million dollars. This is something you do not see in any textbooks and most professors do not go into this, or at least explain it this way.